In general, most value investors like indexing. Buffett and many others agree on this. But why?

1) Most value investors that I have known want ordinary people to have an option of doing pretty well, without investing with them, because the minimums are too high — investing in index funds fits that. Further, Vanguard, who acts in the interest of their investors is an excellent institution. If I could have a fund there and be paid 10-20 basis points, I would do it in a heartbeat.

2) The second reason is less noble. We like less competition. Index money is thought-free money with respect to company and sector selection. The more of a company that is held by index investors, the greater the probability that it is mispriced.

Now, that is not necessarily so crass on our part. Look, good investing for most people is like holding a second job. Do you really want to devote that much of your life to seeking out bargains? Not many will want to do that. (Note: there is a side benefit to doing value investing, no matter what sort of firm you work for. You learn to think like an intelligent businessman — most employees don’t do that. The ability to think like a intelligent businessman sets you up for greater responsibility, because you can not only do your task, but you can consider the deeper questions of business, making you a prime candidate for a promotion.)

But… there is another venue for mispriced stocks. Some large stocks don’t get into the index because they are foreign, or have a large amount of the stock owned by a control group, which makes them less liquid. The main idea is that stocks that few people think about are less liquid, and more likely to be mispriced, but the question remains: are they mispriced high or low?

That is the question for the value investor, and not for those that buy stocks as commodities, as many index investors do.

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In my retirement plan I index, in my regular accounts I do not. In the latter I buy and hold both tax free bonds and a diversified portfolio of mostly large cap domestic and international companies. I seldom sell, unless the original reason I bought the company no longer holds or valuations make selling too compelling not to. What I have notice as my portfolio has grown to around 30 names is that my performance holds fairly close to the weighted blend of S&p 500 and MSCI indices. All I accomplished is making investing a little more interesting and perhaps avoiding capital gains from the trading of stocks active portfolio management brings. It’s really hard to fault indexers.

Unfortunately, the premise of this article is completely flawed, as it assumes all “indexes” are simply S&P 500 or Total Stock portfolios. You are no doubt aware that Vanguard has Large/Mid/Small VALUE indexes as well, right?

Further, for someone wanting more pure, targeted, and consistent exposure to the lowest priced value stocks, the “enhanced” index funds from DFA are close to unbeatable. Sorting on a simple metric of price/book and holding approximately the cheapest 25% (as opposed to 50% for Vanguard and most Value ETFs) of stocks in the respective asset class (while trading patiently, using fund cash-flows to rebalance, lending securities to earn additional revenue), DFA’s large/small value funds in the US, Int’l, and EM markets have trounced their active manager competition. Here are the stats on the % of active value funds in each asset class over the last 10 years (through November) that have been OUTperformed by DFAs simple “structured” approach, which for all intents and purposes are index funds:

And not that it matters much, as these percentages are so high to begin with, but these #s don’t include survivorship bias — something on the order of 40% of value managers that existed 10 years ago have gone out of business, so this outperformance is only measured as a % of those professional value managers that survived!

Somewhere, over some periods, I am sure we can find some value managers who have outperformed an intelligently structured value index portfolio, but the numbers are so small as to be almost irrelevant, and there is no persistence going forward in the # who have been able to pull off the feat.

No, the case is actually quite clear, “active” value investing is dead. All investors would be much better off simply holding broadly diversified, structured/indexed VALUE portfolios. And stop confusing “indexing” with “cap weighted total market index portfolios”. There are a lot of index funds beyond the Russell 3000 and S&P 500.

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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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Copyright David Merkel (c) 2007-2014
Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.
Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.
Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.
Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.